“Play interests me very much,” said Hermann: “but I am not in the position to sacrifice the necessary in the hope of winning the superfluous.”
- Aleksandr Sergeevich Pushkin.
Get your Free
financial review
Some years ago we spent a week at an investment conference in Las Vegas. We had read precisely two books about beating the system before we ever set foot inside a casino.
The first was Thomas A Bass’ The Newtonian Casino. This little-known gem is the (true) account of a bunch of Silicon Valley misfits and hippie drop-outs who make a rudimentary computer in order to beat the roulette table.
Most people who play roulette and favour the even odds game – betting either on black or red, odd or even – end up with a one-way ticket to the poorhouse. That is, they start by betting, say, on black, and if the wheel comes up showing red, they double down on black and keep doing so until they win their stake back. Unless you have a practically infinite pot, you are destined to lose this game. The most you ever stand to win is your original stake back, which, if you think about it, isn’t much of a strategy.
What the hippies of The Newtonian Casino did was a little more sophisticated, not to say scientific. They fashioned an elementary computer out of spare parts, and then made some simple timing machines. (At the time of their experiment, these technologies were not illegal within a casino. Once they’d gone to work, it was.) They realised that there was no predictive value in taking a note of the wheel’s previous spins. Provided the wheel is honest, the past spins have no bearing on future results.
They stood, instead, to benefit from a wrinkle in the procedure of roulette: while the American roulette wheel has a significant advantage over the punters in that it has both a zero and a double-zero slot – giving the table a subtle but powerful statistical edge over gamblers in that all bets on the even plays are void – it is also possible to bet for a short period after the croupier has already sent the ball spinning against the wheel.
Our heroes “simply” deployed their embryonic timing technology in an attempt to predict which quarter of the wheel the ball would land in. They were using not statistical analysis, but Newtonian physics.
They used their basic computer, and some illicit timers hidden inside the sole of a shoe, to attempt to calculate the rate of decay in the spin of the ball versus the rate of decay in the revolution of the wheel – both of which were heading in opposite directions. We won’t give the game away but the book is a wonderful read.
The second was a remarkable and also little-known classic, Norman Leigh’s Thirteen Against the Bank. This book, which we believe is now out of print, is an allegedly true account of a gambler in the 1960s taking a group of friends down to Monte Carlo with the express aim of breaking the bank, again at the roulette table.
The methodology, unlike that deployed by the hippy physicists of The Newtonian Casino, was in this case absolutely statistical. Again, those in Leigh’s team didn’t take a note of previous spins – an honest wheel has no memory. In their case, they bet on black (say), and if the wheel turned out black, they bet again on black, and with a small incremental addition to the size of the bet in return.
What they sought to take advantage of was the statistically rare but feasible outcome whereby the wheel would occasionally throw out a sequence along the lines of: black; black; black; black; black; black; black.
Because they were doubling up, and then some, on each bet, by the time the seventh or eighth sequence of black came through, they would be making some serious money. If, on the other hand, the wheel turned up red, they would simply start again, taking their minimum bet size back to the smallest permissible at the table. And whenever they approached the table limit, and the house stood a chance of getting all its money back, they would just walk away.
(This method is known technically as the reverse Labouchère method, and it is also at the heart of many systematic trend-following methodologies.) The trick is to minimise your downside risk so that you can simply stay in the game for as long as possible. The members of Leigh’s posse achieved their results – again, we won’t spoil this terrific little read – by covering all the tables at once, so as best to maximise their chance of encountering a rare but not impossible sequence of same colour spins.
We mention these two books a) because we thoroughly recommend seeking them out, and b) because having spent some time in Las Vegas, if you must gamble, at least have some semblance of a credible system.
Our own experience of the place was somewhere on the continuum between crass and nauseating. We can’t say we relished the casino environment. Nor, despite staying at the MGM Aria and visiting Caesars Palace and the Bellagio, did we ever see anything even approximating to a real world roulette table. We saw plenty of video versions, though, which is hardly the same thing. And we also saw punters so desperate to be parted from their money that they started playing the slots before they’d even left the airport.
The idea of spending a full two weeks at the resort (despite the quality of the dining and hospitality being admittedly sensational) fills us with horror. Oxygen is pumped into the casinos to keep gamblers awake, refreshed and able to gamble for longer. In many cases food and booze are completely free, as hungry and/or sober gamblers are less likely to bet.
There are no clocks, nor windows showing any natural light, so absent a watch you’ve no idea of what time of day it is or for how long you’ve been feeding that gaudy slot machine. (Most tasteless sponsors of theme-based slot machines? A three-way tie between Betty White – Rose Nylund from The Golden Girls – and The Big Bang Theory and Willy Wonka. Las Vegas is no respecter of childhood, despite the fact that Americans have to be at least 21 just to set foot in the place.)
The carpets are deliberately garish so that when your attention inevitably wanders, you’re shocked back into pumping money into the machines. There is constant background music without crescendos or sudden diminuendos to put you off your stride.
Casinos are constructed like a maze, which is extremely tricky to navigate – at our hotel, it was literally impossible to get from reception to the hotel room without traversing the casino first. The place is a frothy festival of unremitting light and sound, an assault on the senses like nothing else we’ve ever experienced. Still, each to his own: we’re sure some punters enjoy it. From our hotel room we could see the jets taking off from nearby McCarran airport. One every minute.
You can probably sense that inevitable metaphor coming. It’s actually illegal for financial newsletter writers, having visited Las Vegas, not to compare the place to the financial markets. An elaborate ruse to part you from your money? A mob of feckless, weak-minded speculators destined to have their wallets emptied at light speed? We lost count of the number of times we heard the pitiful lament, “But I’m down to my last dollar…”
Actually, the comparison is trite, and ill-founded. The financial markets are precisely what you want them to be. If you want to gamble, great – knock yourself out. Alternatively, you can make the markets your servant, and not your master, which is probably the better bet all round.
When you start out in the City, you tend to regard everything as a bit of a punt. This correspondent was never a trader, however, rather a generalist bond salesman, and we started out in the credit markets rather than in stocks. This had one especial advantage, given that we didn’t study economics (now, we’re hugely relieved that we didn’t, as it would likely have sent us intellectually down one blind alley after another).
The beauty of a background in what the industry calls “fixed income” is that the bond markets teach you pretty much everything about the wider world of “macro”. Bonds are all about interest rates, inflation, monetary policy, foreign exchange, and the interplay between the world’s economies. So a background in bonds gives you a good “crib sheet” to make up for the lack of any educational or theoretical grounding in fundamental economics.
Our biggest suspicion about the world of investing is that most people are trying – and failing – to forecast the future. Our suspicion about equity investors is that many of them are trying simply to predict the direction of the market, whether “the market” is the quantum of global indices, or an entire index like the FTSE 100, or an individual stock. Most investors, in other words, are philosophically still trapped in the casino. In our experience, market predictions are worthless, and trying to forecast the market direction of anything is a waste of time.
What tilts the investment game from random speculation to something far closer to investing is simply the sensible analysis of price. This is a tricky lesson to learn for many, perhaps because the investment game has the same allure as the roulette wheel.
Many “investors” want the game to be exciting, but they’re guilty of a fundamental framing bias. Successful investing isn’t any form of game at all. If you’re enjoying it immensely, there’s a high probability that you’re doing it wrong. It’s obviously enjoyable to experience decent capital gains, but the process of getting there should be treated with a little sober reflection.
Perhaps the most impactful quotation we’ve yet come across about the business of investing was a line in a book by Peter L Bernstein, Against The Gods. Bernstein’s book comes highly recommended, and is a history of risk. Within it, we came across something originally written by Daniel Bernoulli, who was a true Renaissance Man. What Bernoulli said, several centuries ago, was as follows: if you’re managing money for wealthy people, “the practical utility of any gain in value inversely relates to the size of the portfolio.”
In plain English, the more you have, the less you really need. This is an overly crude summation of Bernoulli’s point, but what he was getting at bears repetition and restatement: if you have a meaningful sum of wealth, it should be more important to keep what you have, rather than risk everything in the pursuit of getting more.
In other words, for wealthy investors, capital preservation, in real terms, is a lot more important than capital growth for growth’s sake.
When we first read these words in the late 90s, we were working at Merrill Lynch Private Banking, and we were tasked with managing money for wealthy people. Having spent the last two decades conducting broadly the same activity, we think Bernoulli’s point has a wider application to just about everyone. It isn’t just the wealthy who should be practising capital preservation, it’s everybody.
We appreciate that for investors of moderate means, capital growth looks like the only game in town to achieve their aspirations, but we’re increasingly drawn to the conclusion that a capital preservation, absolute return approach to the markets is the only rational way to behave, especially in an environment of such acute potential threat.
Behavioural economics tends to support Bernoulli’s thesis. We know from work done by the psychologists Daniel Kahneman and Amos Tversky that people tend to be loss averse. That is, we feel the sting of loss far more severely than we appreciate the joy associated with a gain of equivalent value.
Say you are offered £1,000 on a coin toss. If you call it correctly, you will experience some satisfaction at winning £1,000. (You can adjust the bet size to any that represents a meaningful win.) But if you lose the bet, your feeling of regret will, typically, be felt with between two and three times the intensity of that feeling of joy. The loss hurts more.
The conclusion, to us, was and is obvious. Do everything in your power to avoid experiencing the pain of loss.
Among the strategies we can use in the pursuit of loss avoidance:
- Diversify your assets meaningfully. At that Las Vegas conference, several speakers, including ourselves, remarked that true diversification is the only free lunch in finance.
- Moderate your expectations. Many investors have failed to calibrate their return assumptions following the financial crisis. But it isn’t reasonable to expect to make a double-digit return on your portfolio year in, year out, when bond markets are facing an existential crisis, and when recent stock market returns from most developed markets, especially in US Big Tech, have surprised on the upside.
- Where you have strong conviction about investment opportunities, focus on them. While diversification makes complete sense, there is a time and a place when investments can be concentrated. Today, our fiercest conviction is around the valuation and growth opportunity represented by precious metals and by commodities miners.
We would add a caveat: there is always a requirement to manage risk. Within our client portfolios, we typically never allocate more than 10% of a portfolio to any one fund, and we never typically allocate more than 4% to any given stock, no matter how much we might like them. Not everything works as we intended, so a purely mechanistic approach to risk management and position sizing is far better than none at all.
The point we would most like to try and reinforce here is that successful investing is not remotely like buying lottery tickets, or speculating about market direction, or throwing chips at a roulette table.
Provided it’s conducted over a reasonable, medium-term, time frame – probably not less than three or four years – the business of putting your money to work in the financial markets can be transformed from high-risk speculation to rational and ultimately successful investing simply by focusing on sensible and attractive valuations on a bottom-up basis.
Look for shares in companies run by principled, shareholder-friendly management, which throw off bucket-loads of cash in dividends, and which can be bought at a discount to their inherent, or book, value. If you can’t find such businesses, simply wait until you can, and meanwhile diversify into other promising areas.
We think any investor today has to look beyond the stock market, but we still think there are eminently reasonable pockets of value in stocks globally; you just have to remain open-minded. If you share our concerns about general market overvaluation, you will likely share our preference for solid, defensive investments across a wide variety of asset classes, including uncorrelated funds that aren’t linked to the stock or bond markets in any way, and in particular hard assets that will offer protection against systemic crisis or perhaps messy inflation or stagflation.
Diversify sensibly, but concentrate your investments where the valuation opportunities are most compelling.
This isn’t a game.
………….
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio – with no obligation at all:
Get your Free
financial review
…………
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and also in systematic trend-following funds.
“Play interests me very much,” said Hermann: “but I am not in the position to sacrifice the necessary in the hope of winning the superfluous.”
Get your Free
financial review
Some years ago we spent a week at an investment conference in Las Vegas. We had read precisely two books about beating the system before we ever set foot inside a casino.
The first was Thomas A Bass’ The Newtonian Casino. This little-known gem is the (true) account of a bunch of Silicon Valley misfits and hippie drop-outs who make a rudimentary computer in order to beat the roulette table.
Most people who play roulette and favour the even odds game – betting either on black or red, odd or even – end up with a one-way ticket to the poorhouse. That is, they start by betting, say, on black, and if the wheel comes up showing red, they double down on black and keep doing so until they win their stake back. Unless you have a practically infinite pot, you are destined to lose this game. The most you ever stand to win is your original stake back, which, if you think about it, isn’t much of a strategy.
What the hippies of The Newtonian Casino did was a little more sophisticated, not to say scientific. They fashioned an elementary computer out of spare parts, and then made some simple timing machines. (At the time of their experiment, these technologies were not illegal within a casino. Once they’d gone to work, it was.) They realised that there was no predictive value in taking a note of the wheel’s previous spins. Provided the wheel is honest, the past spins have no bearing on future results.
They stood, instead, to benefit from a wrinkle in the procedure of roulette: while the American roulette wheel has a significant advantage over the punters in that it has both a zero and a double-zero slot – giving the table a subtle but powerful statistical edge over gamblers in that all bets on the even plays are void – it is also possible to bet for a short period after the croupier has already sent the ball spinning against the wheel.
Our heroes “simply” deployed their embryonic timing technology in an attempt to predict which quarter of the wheel the ball would land in. They were using not statistical analysis, but Newtonian physics.
They used their basic computer, and some illicit timers hidden inside the sole of a shoe, to attempt to calculate the rate of decay in the spin of the ball versus the rate of decay in the revolution of the wheel – both of which were heading in opposite directions. We won’t give the game away but the book is a wonderful read.
The second was a remarkable and also little-known classic, Norman Leigh’s Thirteen Against the Bank. This book, which we believe is now out of print, is an allegedly true account of a gambler in the 1960s taking a group of friends down to Monte Carlo with the express aim of breaking the bank, again at the roulette table.
The methodology, unlike that deployed by the hippy physicists of The Newtonian Casino, was in this case absolutely statistical. Again, those in Leigh’s team didn’t take a note of previous spins – an honest wheel has no memory. In their case, they bet on black (say), and if the wheel turned out black, they bet again on black, and with a small incremental addition to the size of the bet in return.
What they sought to take advantage of was the statistically rare but feasible outcome whereby the wheel would occasionally throw out a sequence along the lines of: black; black; black; black; black; black; black.
Because they were doubling up, and then some, on each bet, by the time the seventh or eighth sequence of black came through, they would be making some serious money. If, on the other hand, the wheel turned up red, they would simply start again, taking their minimum bet size back to the smallest permissible at the table. And whenever they approached the table limit, and the house stood a chance of getting all its money back, they would just walk away.
(This method is known technically as the reverse Labouchère method, and it is also at the heart of many systematic trend-following methodologies.) The trick is to minimise your downside risk so that you can simply stay in the game for as long as possible. The members of Leigh’s posse achieved their results – again, we won’t spoil this terrific little read – by covering all the tables at once, so as best to maximise their chance of encountering a rare but not impossible sequence of same colour spins.
We mention these two books a) because we thoroughly recommend seeking them out, and b) because having spent some time in Las Vegas, if you must gamble, at least have some semblance of a credible system.
Our own experience of the place was somewhere on the continuum between crass and nauseating. We can’t say we relished the casino environment. Nor, despite staying at the MGM Aria and visiting Caesars Palace and the Bellagio, did we ever see anything even approximating to a real world roulette table. We saw plenty of video versions, though, which is hardly the same thing. And we also saw punters so desperate to be parted from their money that they started playing the slots before they’d even left the airport.
The idea of spending a full two weeks at the resort (despite the quality of the dining and hospitality being admittedly sensational) fills us with horror. Oxygen is pumped into the casinos to keep gamblers awake, refreshed and able to gamble for longer. In many cases food and booze are completely free, as hungry and/or sober gamblers are less likely to bet.
There are no clocks, nor windows showing any natural light, so absent a watch you’ve no idea of what time of day it is or for how long you’ve been feeding that gaudy slot machine. (Most tasteless sponsors of theme-based slot machines? A three-way tie between Betty White – Rose Nylund from The Golden Girls – and The Big Bang Theory and Willy Wonka. Las Vegas is no respecter of childhood, despite the fact that Americans have to be at least 21 just to set foot in the place.)
The carpets are deliberately garish so that when your attention inevitably wanders, you’re shocked back into pumping money into the machines. There is constant background music without crescendos or sudden diminuendos to put you off your stride.
Casinos are constructed like a maze, which is extremely tricky to navigate – at our hotel, it was literally impossible to get from reception to the hotel room without traversing the casino first. The place is a frothy festival of unremitting light and sound, an assault on the senses like nothing else we’ve ever experienced. Still, each to his own: we’re sure some punters enjoy it. From our hotel room we could see the jets taking off from nearby McCarran airport. One every minute.
You can probably sense that inevitable metaphor coming. It’s actually illegal for financial newsletter writers, having visited Las Vegas, not to compare the place to the financial markets. An elaborate ruse to part you from your money? A mob of feckless, weak-minded speculators destined to have their wallets emptied at light speed? We lost count of the number of times we heard the pitiful lament, “But I’m down to my last dollar…”
Actually, the comparison is trite, and ill-founded. The financial markets are precisely what you want them to be. If you want to gamble, great – knock yourself out. Alternatively, you can make the markets your servant, and not your master, which is probably the better bet all round.
When you start out in the City, you tend to regard everything as a bit of a punt. This correspondent was never a trader, however, rather a generalist bond salesman, and we started out in the credit markets rather than in stocks. This had one especial advantage, given that we didn’t study economics (now, we’re hugely relieved that we didn’t, as it would likely have sent us intellectually down one blind alley after another).
The beauty of a background in what the industry calls “fixed income” is that the bond markets teach you pretty much everything about the wider world of “macro”. Bonds are all about interest rates, inflation, monetary policy, foreign exchange, and the interplay between the world’s economies. So a background in bonds gives you a good “crib sheet” to make up for the lack of any educational or theoretical grounding in fundamental economics.
Our biggest suspicion about the world of investing is that most people are trying – and failing – to forecast the future. Our suspicion about equity investors is that many of them are trying simply to predict the direction of the market, whether “the market” is the quantum of global indices, or an entire index like the FTSE 100, or an individual stock. Most investors, in other words, are philosophically still trapped in the casino. In our experience, market predictions are worthless, and trying to forecast the market direction of anything is a waste of time.
What tilts the investment game from random speculation to something far closer to investing is simply the sensible analysis of price. This is a tricky lesson to learn for many, perhaps because the investment game has the same allure as the roulette wheel.
Many “investors” want the game to be exciting, but they’re guilty of a fundamental framing bias. Successful investing isn’t any form of game at all. If you’re enjoying it immensely, there’s a high probability that you’re doing it wrong. It’s obviously enjoyable to experience decent capital gains, but the process of getting there should be treated with a little sober reflection.
Perhaps the most impactful quotation we’ve yet come across about the business of investing was a line in a book by Peter L Bernstein, Against The Gods. Bernstein’s book comes highly recommended, and is a history of risk. Within it, we came across something originally written by Daniel Bernoulli, who was a true Renaissance Man. What Bernoulli said, several centuries ago, was as follows: if you’re managing money for wealthy people, “the practical utility of any gain in value inversely relates to the size of the portfolio.”
In plain English, the more you have, the less you really need. This is an overly crude summation of Bernoulli’s point, but what he was getting at bears repetition and restatement: if you have a meaningful sum of wealth, it should be more important to keep what you have, rather than risk everything in the pursuit of getting more.
In other words, for wealthy investors, capital preservation, in real terms, is a lot more important than capital growth for growth’s sake.
When we first read these words in the late 90s, we were working at Merrill Lynch Private Banking, and we were tasked with managing money for wealthy people. Having spent the last two decades conducting broadly the same activity, we think Bernoulli’s point has a wider application to just about everyone. It isn’t just the wealthy who should be practising capital preservation, it’s everybody.
We appreciate that for investors of moderate means, capital growth looks like the only game in town to achieve their aspirations, but we’re increasingly drawn to the conclusion that a capital preservation, absolute return approach to the markets is the only rational way to behave, especially in an environment of such acute potential threat.
Behavioural economics tends to support Bernoulli’s thesis. We know from work done by the psychologists Daniel Kahneman and Amos Tversky that people tend to be loss averse. That is, we feel the sting of loss far more severely than we appreciate the joy associated with a gain of equivalent value.
Say you are offered £1,000 on a coin toss. If you call it correctly, you will experience some satisfaction at winning £1,000. (You can adjust the bet size to any that represents a meaningful win.) But if you lose the bet, your feeling of regret will, typically, be felt with between two and three times the intensity of that feeling of joy. The loss hurts more.
The conclusion, to us, was and is obvious. Do everything in your power to avoid experiencing the pain of loss.
Among the strategies we can use in the pursuit of loss avoidance:
We would add a caveat: there is always a requirement to manage risk. Within our client portfolios, we typically never allocate more than 10% of a portfolio to any one fund, and we never typically allocate more than 4% to any given stock, no matter how much we might like them. Not everything works as we intended, so a purely mechanistic approach to risk management and position sizing is far better than none at all.
The point we would most like to try and reinforce here is that successful investing is not remotely like buying lottery tickets, or speculating about market direction, or throwing chips at a roulette table.
Provided it’s conducted over a reasonable, medium-term, time frame – probably not less than three or four years – the business of putting your money to work in the financial markets can be transformed from high-risk speculation to rational and ultimately successful investing simply by focusing on sensible and attractive valuations on a bottom-up basis.
Look for shares in companies run by principled, shareholder-friendly management, which throw off bucket-loads of cash in dividends, and which can be bought at a discount to their inherent, or book, value. If you can’t find such businesses, simply wait until you can, and meanwhile diversify into other promising areas.
We think any investor today has to look beyond the stock market, but we still think there are eminently reasonable pockets of value in stocks globally; you just have to remain open-minded. If you share our concerns about general market overvaluation, you will likely share our preference for solid, defensive investments across a wide variety of asset classes, including uncorrelated funds that aren’t linked to the stock or bond markets in any way, and in particular hard assets that will offer protection against systemic crisis or perhaps messy inflation or stagflation.
Diversify sensibly, but concentrate your investments where the valuation opportunities are most compelling.
This isn’t a game.
………….
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio – with no obligation at all:
Get your Free
financial review
…………
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and also in systematic trend-following funds.
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